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Stop Limit vs. Stop Loss: Orders Explained

There's a subtle -- yet important -- difference between stop-loss and stop-limit orders.

I am new to trading and do not understand the difference between a stop limit and a stop loss. What is the difference between the two order types and when should each be used? Thanks, A.Y.

Gregg Greenberg

: There's a subtle, yet important, difference between stop-loss and stop-limit orders. And it matters most when things, as they occasionally do on Wall Street, get a little out of control.

A stop-loss order becomes a market order when a security sells at or below the specified stop price. It is most often used as protection against a serious drop in the price of your stock.

So let's say you own stock XYZ and it is trading at $20. It's a volatile stock, so you put a stop-loss order on at $15. That means that if the stock falls to $15 or below, your order becomes a market order and will be sold immediately at the best available price.

In theory, XYZ could be sold above your stop-loss price of $15 if the stock touches $15 and then rebounds. Or it could sell well below your stop-loss price at, say, $14, if the stock keeps cratering in a fast-moving market.

Now, you might not have wanted to sell the stock unless it went below $15, but you are out of luck, because you put in a stop-loss order, not a stop-limit order. A stop-limit order becomes a limit order -- not a market order -- when a specified price level has been reached.

That means if XYZ touches $15 in a fast-moving market, triggering the stop, then it will have to hit $15 again (the limit) for the order to be executed.

It's worth noting that XYZ could also open below $15 if some really horrific news is announced before the market opens. Let's say the stock opens at $12.50. In that case, a stop-loss order immediately turns into a market order and will be sold around the $12.50 price.

A stop-limit order at $15 in such a scenario would not be exercised, since the stock falls from $20 to $12.50 without touching $15. That's why a stop loss offers greater protection for fast-moving stocks.

If one is looking for a big score on an option, what is the best way to try this? Thanks, J.B.

The surest way to lose money on Wall Street is to search for the so-called big score. And to try to do so using options? Well, in that case you might as well donate your money to charity, because you obviously won't be holding it for very long.

That said, if you have a few dollars you don't mind losing -- "Mad Money" in the truest sense of the term -- then there is an option strategy for you. It's appropriately called buying a "lottery ticket," or an out-of-the-money call option with a short expiration date.

Let's say, for example, that you had a dream around March 16 that fictional ABCD Corp. will have the luck of the Irish and announce a tremendously positive deal on the morning of St. Patrick's Day, March 17. You have no evidence of this deal, because that would be insider trading, but your vision was so clear that you are willing to risk some Mad Money on it.

And, as luck would have it, March 17 also happens to be an options expiration date, because it's the third Friday of the month.

Now, let's also say that ABCD is trading at $20 per share on March 16, the day before expiration. But you think this fictional deal will catapult the stock to $23 a share when it is announced the next morning.

So, with visions of this deal dancing in your head, how can you earn the maximum return by putting down the least amount of money?

One strategy is to buy a March $22.50 call option. And since ABCD is currently trading well under the strike price of $22.50, it is also considered an "out-of-the-money-option."

A call option gives the buyer of the call the right, but not the obligation, to buy the underlying stock at the option's strike price, which in this case is $22.50. The seller of the call is obligated to deliver (sell) the underlying stock at the option's strike price when the buyer exercises his right.

Since you are only allowing yourself a single day for the stock to move from its price of $20 past its strike price of $22.50, the price of the option is dirt cheap at 5 cents a share. One option contract represents a hundred shares, so therefore the price of the contract is $5. That's where the leverage comes in for the big score.

You buy the ABCD call option for $5 on March 16 when the stock is at $20. Then you wake up the next morning to see that, praise the lord, the fantasy deal came through. The stock jumps to $23 a share and closes at that price.

Since the stock closed at $23 a share, the value of your option will jump to 50 cents from 5 cents, because the call is expiring 50 cents "in-the-money." Or, in other words, the positive difference between the price of the stock, $23, and the strike price of your option, $22.50.

There you have it. In the end, your lottery ticket paid off 10 times over. Your $5 dollar contract is now worth $50 in just a day!

Now, wake up! Because all the shamrocks in Ireland won't give you enough luck to make this trade more than a dream.

Of course, there are ways to increase the chances of a so-called lottery ticket paying off, either by increasing the amount of time before expiration or by lowering the strike price.

But if you want to wish upon a star, that's how you can do it. Just don't do it with my money.